PIMCO's CEFs Trading At High Premiums: Is There A PIMCO 'Put'?

by: Joe Eqcome

PIMCO sponsored CEFs enjoy a significantly higher premium relative to its CEF sponsored peer group ("peer group"). This appears unsupportable based on our comparative fundamental analyses on both a nominal and risk-adjusted basis. This suggests an implied and intangible "franchise value" awarded to the PIMCO organization for which investors are willing to "pay up" to invest in PIMCO sponsored CEFs relative to other large, multiple CEF sponsors such as Nuveen, BlackRock, MFS, etc.

Sawdust in the Oats: We believe that PIMCO should enjoy a small, relative premium valuation versus similar CEFs based on its size, track record and the visibility of its co-founder Bill Gross. However, we also believe that its average premium relative to its peer group has become excessive and investors are currently overpaying for PIMCO's "franchise value".

Currently, investors must accept a 2.2% premium valuation for each annualized distribution yield percentage versus 0.7% for its peer group. Investors would accept somewhat similar results on a risk-adjusted basis (see table below).

Basis for a Premium Valuation: The basis for PIMCO's intangible "franchise value" may stem from two primary sources. The first is defensible, the second is not.

1. PIMCO "Brand": This is no different than a branded grocery store product such as "Tide" laundry detergent. A PIMCO "brand" can be reasonably imputed based upon its success, the size of its organization (largest bond advisor) and the visibility of its co-founder Bill Gross who has been crowned the "bond king" (this is not intended to be pejorative-it's a fact).

2. PIMCO "Put": Unlike the Fed, investors' may have an unreasonable expectation of an implied "put" to the PIMCO organization. Due to PIMCO's vast trading and investment operations, investors may believe that PIMCO has the ability to allocate investments and revenues to specific funds enabling it to "shore-up" its CEFs-or other funds-that may be temporarily underperforming its investment objectives.

Reality versus Expectation: Whether PIMCO could make such timely allocations is unlikely and beyond the scope of this inquiry. More importantly, the question remains: Is there an implied "put" expectation by investors?

If there is no PIMCO "put" feature, then its "franchise value" would be based on PIMCO's "brand" relative to its peers. Since PIMCO's peers represent formidable competitors, the likes of BlackRock and Nuveen, such comparisons are legitimate. Then the question becomes: What do you pay for the PIMCO "brand" and when are you paying too much?

Comparative Analysis: Of the major fixed-income sponsors of multiple CEFs, PIMCO's CEFs trade at a significantly higher average premium compared to its peer group (see table). All (100%) of PIMCO's CEFs currently trade at premiums at the time of our pricing (4/5/12). This compares on average with 46.8% of its peer group as well as 42.5% of all fixed-income CEFs used for purpose of this comparison (HiYldBndFnds, National & State Munis and OtherFnds).

Significant Difference: As the table illustrates, the premium comparisons are stark. The average premium for all PIMCO's CEFs is 16.6% versus an average of 1.2% for its peer group and a discount of 0.1% for the broader fixed-income CEFs universe. For those CEFs that are trading at a premium, PIMCO's average premium was 16.6% (as all are trading at a premium at the time of pricing) versus 5.2% for the sponsor peer group and 5.6% for the comparable fixed-income universe.

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Compare and Contrast: Part of the reason for the average higher valuation of PIMCO's CEFs may lie in the fact that it generates a higher average annualized distribution yield of 7.7% versus 6.8% for its peer group. Many retail investors seek higher yields and ignore premium/discount valuations only to have the latter come back to "bite" them at a later date.

Component Parts: PIMCO's higher average yield may be a function of its higher average total net assets. PIMCO's net assets averaged $628 million versus $539 million for its peer group. Part of this difference may be the fact that PIMCO sponsored CEFs use greater average leverage: 40.2% versus 31.8% for its peer group and 27.4% for its broader fixed-income cohort group. As a result of the higher leverage, PIMCO's CEFs generate an average 3-year standard deviation of 15.7% versus 10.2% for its peer group. This would indicate greater volatility of investment return thereby reducing its risk-adjusted total return.

Sum of the Parts: If investors were to only focus on yield as an investment criterion and ignore share price/NAV premium, then investors must be willing to accepting an average 2.2% premium for every percent of annualized yield in the case of PIMCO sponsored CEFs trading at a premium. This would be in dramatic contrast to an average 0.7% premium for every percent of annualized yield for its CEF sponsor peer group.

On a Total Return Basis: Even when YTD total return is taken into consideration, for which PIMCO has a greater average YTD price appreciation of 5.6% versus 3.5% for its peer group, on a risk adjusted basis investors must be willing to accept 1.6% premium per percentage of annualized yield versus 0.5% for its peer group.

Concerns: The danger inherent in PIMCO's CEFs on average is its higher-leverage, greater investment return volatility and a rich valuation. An escalation in interest could cause a severe diminution of shareholders' value-albeit, that day may be far off on the horizon.

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PIMCO's CEFs deserve to trade at a slight premium, but it appears to us to be currently overvalued based on a comparison to its peer group and also to the larger comparable universe. Particularly in the absence of any PIMCO "put".

In the interim, PIMCO's CEFs may continue to enjoy this higher valuation based on no-cost debt, high nominal yield, investors seeking safety in fixed-income investments and the increasing likelihood of a QE3. In times of fear and uncertainty, investors make irrational decisions that support excessive valuation, until they don't.

It's like the story that ends, " ... we know what you are, now we're just negotiating price".

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.